"Perhaps the bubbles in asset prices that were suppressed would only pop up somewhere else"

Nick Rowe weighs in with an idea I just tossed in the bin:

"The Bank of Canada should peg the TSE 300" - revisited

"The Bank of Canada should peg the TSE-300" is the title of a Carleton Economics Department working paper I wrote in 1992. (Sorry, but no web version available; this was in the olden days when all we had was paper, and when the TSX was the TSE.) Given the recent turmoil in financial markets, and the renewed interest in having central banks look at asset prices, I was wondering whether to resurrect this paper, but dithered. Now Roger Farmer has beaten me to it. Mark Thoma posted it on his blog, and Tyler Cowen on his.

The reactions in the comments are mostly either unfavourable, or incredulous. I thought I would write a few words in defence of the idea, and then say why I no longer support it( THANK GOD ).

Many critics are just confused, and think that using monetary policy to peg an index of stock prices is some sort of interventionist policy that prevents markets finding their own equilibrium. But if governments produce money, and they do, then governments have to decide how much money to produce. They have to target something( TRUE ). That something can be the price of gold, or silver, or the exchange rate with another government's money, or the CPI (as in inflation targeting). Or it can be an index of stock prices. In principle, any nominal (measured in dollars) variable can be the target for monetary policy, and the TSX 300 is a nominal variable.

Pegging the TSX 300 is no more interventionist( OK. BUT WHAT IS THE TARGETING FOR? ) than pegging the price of gold, or pegging the CPI (as we do now with inflation targeting). In the long run( BUT CAN IT EFFECT THE SHORT RUN? ), market forces determine the real (inflation-adjusted) value of the TSX 300 even if the Bank of Canada pegs the nominal value; the same is true if the Bank of Canada pegs the price of gold. If this bothers you, just think of the Bank of Canada pegging the value of the Canadian dollar to the TSX 300, rather than vice-versa.

Let me be more precise. My 1992 proposal was that the Bank of Canada should peg the time-path of the total return index of the TSX 300, so it would grow at some fixed rate of (say) 7% per year. The total return index is a better target then the index itself, because it is immune to arbitrary changes in firms' dividend payout ratios.

There is one very curious effect of pegging the total return index to grow at (say) 7% per year. It would mean that a stock index fund would be as safe an investment as Canada Savings Bonds are now, since the holder would be certain of the nominal interest rate (but the real interest rate would be uncertain in both cases). It would be hard to imagine that the equity premium could persist, which could be an important advantage of the policy. All nominal interest rates on government bonds and other safe assets would have to pay the same 7% per year. The TSX 300 would be an ideal investment for widows and orphans.

The main rationale for the policy would be the hope( OK ) that it would tame financial bubbles and crises. Also, if stock prices predict the business cycle, and if this correlation implies causation, taming stock prices might also tame the business cycle.( IT'S A REGULATOR )

It seemed to me a good idea in 1992, but this was before inflation targeting really got off the ground, so I didn't have much to compare it to. A few years ago, when inflation targeting seemed to be performing very well, I changed my mind, and decided it was "very interesting....but stupid". Now I am just uncertain. Here are the main problems.

First, stock prices are very flexible, but a lot of goods prices are very sticky. There is a long-standing principle in macroeconomics that business cyles are caused by sticky prices, and the best macroeconomic policy is to make sure that the prices which don't change quickly don't have to change quickly( A GOOD POINT ). This principle suggests we should target an index of sticky prices (or wages), and the CPI comes a lot closer to this than the TSX 300.

Second, the real fundamental equilibrium value of the TSX 300 can change by a large amount very quickly, due to fundamental changes in profitability, the growth rate of profits, or real discount rates. But if the nominal value of the TSX 300 were pegged, the only way the real value of the TSX 300 could reach its new equilibrium would be for the CPI to adjust. Big fluctuations in the CPI would be undesirable if they did occur, and even more undesirable if they needed to occur but couldn't, because goods prices are sticky. For example, a cut in corporate taxes which would cause a (say) 20% rise in stock prices when the Bank targets the CPI would instead have to cause a 20% decline in the CPI if the Bank targets stock prices.

Finally, the stock market is perhaps a barometer of the state of the economy, but we cannot be sure that pegging the barometer would stabilise the weather. Goodhart's law...(((

Although Goodhart's law has been expressed in a variety of formulations, the essence of the law is that once a social or economic indicator or other surrogate measure is made a target for the purpose of conducting social or economic policy, then it will lose the information content that would qualify it to play such a role. The law was named for its developer, Charles Goodhart (a chief economic advisor to the Bank of England).

The law was first stated in a 1975 paper by Goodhart and gained popularity in the context of the attempt by the United Kingdom government of Margaret Thatcher to conduct monetary policy on the basis of targets for broad and narrow money, but the idea is considerably older. It is implicit in the economic idea of rational expectations. While it originated in the context of market responses the Law has profound implications for the selection of high-level targets in organisations^[1].

It has been asserted that the stability of the economic recovery that took place in the United Kingdom under John Major's government from late 1992 onwards was a result of Reverse Goodhart's Law: that, if a government's economic credibility is sufficiently damaged, then its targets are seen as irrelevant and the economic indicators regain their reliability as a guide to policy)))

...suggests the opposite. Perhaps the bubbles in asset prices that were suppressed would only pop up somewhere else. Indeed, the classical dichotomy suggests that they would pop up somewhere else( YES ); positive asset price bubbles would pop us as negative CPI bubbles.

I'm not prepared to rule out targeting some weighted average of goods prices and asset prices. But even a broad index of stock prices is a narrow representation of even financial assets, let alone land, houses, and human capital."

I don't like Mechanical Interventions, which this is. It's, in effect, a regulator. I simply don't buy it any more than using interest rates to stop bubbles. It's too blunt an instrument, and I don't believe that it addresses the insurance needed to prevent calling runs. In other words, if it doesn't work, the illusion of safety will lead to another ghastly blowup. By the way, any regulator must be set, which is another reason I don't like it. Economists don't qualify as engineers.

There must be a hundred ways people believe that we can prevent bubbles, and, if we have a Treasury Bubble now which bursts, they won't even be noticing one right in front of their faces. Bagehot's Principles are the ticket. Stop printing up false ones.